The need for a Central Bank Digital Currency (CBDC)

JP Koning offers a Canadian perspective on the need for a CBDC that identifies two issues with the idea and concludes it is not a priority.

His argument rests on two planks. Firstly he argues that the existing payment infrastructure in Canada is pretty good so the obvious question is whether the CBDC is really worth the required investment of public resources. Secondly he highlights the operational and governance problems associated with payments that lie outside a central bank’s core area of competence.

His post also links to an article by David Andolfatto that arrives at similar conclusions. David however adds the qualification that a wholesale CBDC might be worth pursuing.

Neither post introduces anything radically new into the discussion of CBDC so far as I can tell but they are worth reading to get a Canadian perspective. The key points the articles reinforced for me where:

  1. That the need for financial innovations like a CBDC (or indeed payment stablecoins) depends a lot on how good the existing payment rails are. Some countries have pretty good systems but others (which surprisingly seems to include America) are not keeping up with best practice.
  2. Cross currency payments is an area that appears ripe for disruption and a wholesale CBDC might have a role to play in this process.

Tony – From the Outside

The problem with regulating stablecoin issuers like banks

One of my recent posts discussed the Report on Stablecoins published in November 2021 by the President’s Working Group on Financial Markets (PWG). While I fully supported the principle that similar types of economic activities should be subject to equivalent forms of regulation in order to avoid regulatory arbitrage, I also wrote that it was not obvious to me that bank regulation is the right answer for payment stablecoin issuance.

This speech by Governor Waller of the Fed neatly expresses one of the key problems with the recommendation that stablecoin issuance be restricted to depositary institutions (aka private banks). To be honest I was actually quite surprised the PWG arrived at this recommendation given the obvious implication that it would benefit the bank incumbents and impede innovation in the ways in which US consumers can access money payment services

“However, I disagree with the notion that stablecoin issuance can or should only be conducted by banks, simply because of the nature of the liability. I understand the attraction of forcing a new product into an old, familiar structure. But that approach and mindset would eliminate a key benefit of a stablecoin arrangement—that it serves as a viable competitor to banking organizations in their role as payment providers. The Federal Reserve and the Congress have long recognized the value in a vibrant, diverse payment system, which benefits from private-sector innovation. That innovation can come from outside the banking sector, and we should not be surprised when it crops up in a commercial context, particularly in Silicon Valley. When it does, we should give those innovations the chance to compete with other systems and providers—including banks—on a clear and level playing field”

“Reflections on stablecoins and Payments Innovations”, Governor Christopher J Waller, 17 November 2021

The future of payment stablecoins is, I believe, a regulated one but I suspect that the specific path of regulation proposed by the PWG Report recommendations will (and should) face a lot of pushback given its implications for competition and innovation in the financial payment rails that support economic activity.

I don’t agree with everything that Governor Waller argues in his speech. I am less convinced than he, for example, that anti trust regulation as it stands offers sufficient protection against big tech companies operating in this space using customer data in ways that are not fully aligned with the customers’ interests. That said, his core argument that preserving the capacity for competition and financial innovation in order to keep the incumbents honest and responsive to customer interests is fundamental to the long term health of the financial system rings very true to me.

For anyone interested in the question of why the United States appears to be lagging other countries in developing its payments infrastructure, I can recommend a paper by Catalini and Lilley (2021) that I linked to in this post. This post by JP Koning discussing what other countries (including Australia) have achieved with fast payment system initiatives also gives a useful sense of what is being done to enhance the existing infrastructure when the system is open to change.

Tony – From the Outside

The future of stablecoin issuance appears to lie in becoming more like a bank

Well to be precise, the future of “payment stablecoins” seems to lie in some form of bank like regulation. That is one of the main conclusions to be drawn from reading the “Report on Stablecoins” published by the President’s Working Group on Financial Markets (PWG).

One of the keys to reading this report is to recognise that its recommendation are focussed solely on “payment stablecoins” which it defines as “… those stablecoins that are designed to maintain a stable value relative to a fiat currency and, therefore, have the potential to be used as a widespread means of payment.”

Some of the critiques I have seen from the crypto community argue that the report’s recommendations fail to appreciate the way in which stablecoin arrangements are designed to be self policing and cite the fact that the arrangements have to date withstood significant episodes of volatility without holders losing faith. Market discipline, they argue, makes regulation redundant and an impediment to experimentation and innovation.

The regulation kills innovation argument is a good one but what I think it misses is that the evidence in support of a market discipline solution is drawn from the existing uses and users of stablecoins which are for the most part confined to engaged and relatively knowledgeable participants. This group of financial pioneers have made a conscious decision to step outside the boundaries of the regulated financial system (with the protections that it offers) and can take the outcomes (positive and negative) without having systemic prudential impacts.

The PWG Report looks past the existing applications to a world in which stablecoins represent a material alternative to the existing bank based payment system. In this future state of the world, world stablecoins are being used by ordinary people and the question then becomes why this type of money is any different to private bank created money once it becomes widely accepted and the financial system starts to depend on it to facilitate economic activity.

The guiding principle is (not surprisingly) that similar types of economic activity should be subject to equivalent forms of regulation. Regulatory arbitrage rarely (if ever) ends up well. This is a sound basis for approaching the stablecoin question but it is not obvious to me that bank regulation is the right answer. To understand why, I recommend you read this briefing note published by Davis Polk (a US law firm), in particular the section titled “A puzzling omission” which explores the question why the Report appears to prohibit stablecoin issuers from structuring themselves as 100% reserve banks (aka “narrow banks”).

4. A puzzling omission.

By recommending that Congress require all stablecoin issuers to be IDIs, the Report would effectively require all stablecoin issuers to engage in fractional reserve banking and effectively prohibit them from being structured as 100% reserve banks (i.e., narrow banks9) that limit their activities to the issuance of stablecoins fully backed by a 100% reserve of cash or cash equivalents.10

The reason is that IDIs are subject to minimum leverage capital ratios that were calibrated for banks that engage in fractional reserve banking and invest the vast portion of the funds they raise through deposit-taking in commercial loans or other illiquid assets that are riskier but generate higher returns than cash or cash equivalents. Minimum leverage ratios treat cash and cash equivalents as if they had the same risk and return profile as commercial loans, commercial paper and long-term corporate debt, even though they do not. Unless Congress recalibrated the minimum leverage capital ratios to reflect the lower risk and return profile of IDIs that limit their assets to cash and cash equivalents, the minimum leverage capital ratios would make the 100% reserve model for stablecoin issuance uneconomic and therefore effectively prohibited.11 It is puzzling why the PWG, FDIC and OCC would recommend a regulatory framework that would effectively require stablecoin issuers to invest in riskier assets and rely on FDIC insurance rather than permitting stablecoins backed by a 100% cash and cash equivalent reserve.

This omission is puzzling for another reason. There has long been a debate whether deposit insurance schemes or a regime that required demand deposits to be 100% backed by cash or cash equivalents would be more effective in preventing runs or contagion. Indeed, the Roosevelt Administration, Senator Carter Glass, a number of economists and most well-capitalized banks were initially opposed to the proposal to create a federal deposit insurance scheme in 1933.12 Among the arguments against deposit insurance are that the benefits of deposit insurance in the form of reduced run and contagion risk are outweighed by the adverse effects in the form of reduced market discipline resulting from the reduced incentive of depositors to monitor the financial health of their banks. This reduced monitoring gives weaker banks more room to engage in risky activities the costs of which are borne by the stronger and more responsible banks in the form of excessive deposit insurance premiums or by taxpayers in the form of government bailouts.

In a competing proposal that has come to be known as the Chicago Plan, a group of economists led by economists at the University of Chicago argued in favor of a legal regime that required all demand deposits to be 100% backed by a reserve of cash or cash equivalents.13 Proponents of the Chicago Plan argued that it would be more effective in stemming runs and contagion than the proposed federal deposit insurance scheme, without undermining market discipline or creating moral hazard. The Chicago Plan would have been analogous to the original National Bank Act that required all paper currency issued by national banks to be fully backed 100% by U.S. Treasury securities. The Chicago Plan was ultimately rejected in favor of the federal deposit insurance scheme that was enacted in 1933 not because it would have been less effective than deposit insurance in stemming runs and contagion, but because it was viewed as too radical. Policymakers feared that by prohibiting banks from using deposits to fund commercial loans and invest in other debt instruments, the Chicago Plan would have resulted in a further contraction in the already severely contracted supply of credit that was fueling the great contraction in economic output that later became known as the Great Depression.

It is understandable why the Report does not recommend prohibiting IDIs from issuing, transferring or buying and selling stablecoins that represent insured deposit liabilities. What is puzzling in light of this history, however, is why the Report would effectively prohibit stablecoin issuers from structuring themselves as 100% reserve (i.e., narrow) banks that limit their activities to the issuance, transfer and buying and selling stablecoins fully backed by a 100% reserve of cash or cash equivalents.

“U.S. regulators speak on stableman and crypto regulation” Davis Polk Client Update, 12 November 2021

I am open to the possibility that the conventional bank regulation solution was unintended and that a narrow bank option might still be on the table. In that regard, I note that Circle has been pursuing the 100% reserve bank option for some time already so it would have been reasonable to expect that the PWG Report to discuss why this was not an option if they were ruling it out. The value of the Davis Polk note is that it neatly explains why being required to operate under bank regulation (the Leverage Ratio in particular) will be problematic for the stablecoin business model. This will be especially useful for those in the stablecoin community who may believe that fractional reserve banking is a free option to increase the riskiness of the assets that back the stablecoin liabilities.

But, as always, I may be missing something…

Tony – From the Outside

Reserves of top stablecoins

This graph from an IMF blog neatly summarises the considerable diversity in the asset backing of stablecoins. While the IMF blog highlights the risks associated with stablecoins, I prefer to remain open to the possibility that they represent a new vector of competition that will force traditional banking to lift its game.

That possibility does however (for me at least) require that the banking regulators develop a stablecoin regulatory model that is fit for purpose. I am yet to see any jurisdiction that appears to be offering a good model for how this might be done but welcome any suggestions on what I am not seeing.

In the interim, JP Koning did a good post summarising the regulatory models he saw being pursued by stablecoin issuers.

Tony – From the Outside

M-Pesa and the African Fintech Revolution – by Marc Rubinstein – Net Interest

You, like me, might be vaguely aware of the M-Pesa story of fintech innovation in Africa. Marc Rubinstein offers one of the best accounts I have encountered of how this came about and where it might be headed. Especially interesting is his analysis of why it took off in Kenya and the challenges it has faced in other markets.

You can find Marc’s post here – www.netinterest.co/p/m-pesa-and-the-african-fintech-revolution-3c1

Tony – From the Outside

Finance cartels face digital currency shake-up | Financial Times

Cross border payment is one of the areas of conventional banking where challengers believe that crypto/DLT solutions can shake up the existing order. There is little doubt that the cross border payment status quo has lots of room for improvement but Gillian Tett (Financial Times) offers a nice summary of central bank projects that are potentially introducing other vectors of innovation and competition.

— Read on www.ft.com/content/4ab25f71-78ff-40a2-b47c-e04075ea81b4

Why is the United States lagging behind in payments?

… is the title of a useful paper by Christian Catalini and Andrew Lilley that digs into the puzzle of why it is that one of the (if not the) key players in the global financial system seems to lagging global best practice in terms of the cost, convenience and speed of its payment system.

It has to be noted that the authors are not neutral observers in this space. Christian Catalini is the Chief Economist of the Diem Association and Diem Networks US, and Co-Creator of Diem (formerly Libra). He is also the Founder of the MIT Cryptoeconomics Lab and a Research Scientist at MIT. Andrew Lilley is an employee of Novi Financial, Inc. who contributed to the paper as part of his work with Diem Networks US. With that caveat in mind, the paper still offers a short (12 pages) and useful summary of the ways in which the US lags best practice.

They frame the US problem as follows:

The US enjoys one of the least concentrated banking systems among the G30, but this feature has also created a fragmented and expensive payments system. Transfers between major US banks incur fees ranging from $10 to $35 for same-day wires, and up to $3 for 2-day transactions. Compare this to the UK, where individuals and businesses have access to a free, 24/7 interbank payments system which settles within seconds and supports over 8M transactions per day. While the US does have a Real Time Gross Settlement (RTGS) system, the Fedwire Funds Service carries less than 1 million transactions per day, has limited 21/5 availability, and is almost exclusively used by financial institutions and large corporations. Its fees, moreover, are larger than alternative payment methods such as ACH, creating a trade-off between cost and immediacy. Private sector alternatives are limited, and while some banks have deployed real-time solutions, these come with transaction limits and little adoption, which severely reduces their usefulness.

Catalini and Lilley (2021), Why is the United States Lagging Behind in Payments?

The paper then outlines how these limitations affect individuals, business and government and concludes with suggestions of what might be done to address the problems discussed:

There are at least three ways to remove frictions in payments and rapidly expand the number of individuals and businesses that can access the financial system and cheaply transact in real time. The first is to bring deposits on a single ledger through a Central Bank Digital Currency (CBDC), so that transfers between banks are not limited by external liquidity constraints or third-party rails. The second approach is to follow countries such as India and Mexico and increase the throughput of always-on RTGS systems. This is the model the Federal Reserve is pursuing with the introduction of FedNow, targeted for 2023. FedNow, however, is expected to have an initial transfer maximum of $25,000, which would limit its usefulness to businesses. The third approach is to facilitate the growth of interoperable, stablecoin payment rails by creating the right regulatory framework for these new types of networks to safely increase competition in payments.

While each one of these approaches presents different challenges, opportunities and trade-offs in terms of complexity, development costs and ability to expand access to segments that are currently excluded, it is important to stress that they are likely to be complements, not substitutes.

Advancing the US payments infrastructure will require both regulatory and technical developments targeted at improving market structure, lowering barriers to entry, and facilitating collaboration between public and private sector efforts in digital payments.

Catalini and Lilley (2021)

I am trying to keep an open mind on the future of payment systems but find myself drawn towards the conclusion that fast payment systems that the FedNow initiative is based on seem to have worked pretty well in other countries in terms of improving cost, speed and convenience so it is not obvious to me why either a CBDC or stablecoin solution is necessary in the United States.

If you want to explore these issues further, JP Koning recently offered a nice summary of what has been achieved by fast payment systems in other countries while a speech (“CBDC: A solution in Search of a Problem?”) by Governor Waller of the US Federal Reserve neatly summarises the issues associated with whether a CBDC is necessary or desirable (at least so far as the USA is concerned). It is important to recognise however that the conclusions that Waller draws do not necessarily apply to other countries (China being the prime example) which are responding to very different types of payment systems.

Let me know what I am missing

Tony – From the Outside

Progress in fast payment systems

As we contemplate new forms of money (both Central Bank Digital Currencies and new forms of private money like stablecoins), JP Koning makes the case that the modern payment systems available in the conventional financial system have improved more than is often appreciated …

The speeding up of modern payments is a great success story. Let me tell you a bit about it.To begin with, central banks and other public clearinghouses have spent the last 15-or-so years blanketing the globe with real-time retail payments systems. Europe has TIPS, UK has Faster Payments, India has IMPS, Sweden has BiR, Singapore FAST. There must be at least thirty or forty of these real-time retail payments system by now. 

The speed of these new platforms get passed on to the public by banks and fintechs, which are themselves connected to these core systems.

That is not to say they are perfect but it is helpful to properly understand what has been done already in order to better understand what the new forms truely offer.

You can read his post here ..

http://jpkoning.blogspot.com/2021/07/those-70s-ach-payments.html

Tony – From the Outside

The meltdown of IRON

Kudos to “Irony Holder” for a great title to an equally interesting post exploring what went wrong with the IRON stablecoin. My last post “A bank run in CryptoLand” flagged a short summary of the demise of IRON in Matt Levine’s Money Stuff column in Bloomberg and Matt’s latest column put me onto Irony Holder for a more detailed account of what went wrong. I suspect that I will be returning to the stablecoin topic many times before I am done.

One of the challenges in banking and finance is figuring our what is “new and useful” versus what is simply a “new way of repeating past mistakes” and stablecoins offer a rich palette for exploring this question. I remain open to the possibility that stablecoins will produce something more than a useful tool for managing trading in cryptoassets. The potential to make low value international payments cheaper and faster seems like one of the obvious places where the existing financial system could be improved on.

However, it seems equally likely that stablecoin innovation will repeat mistakes of the past so these post mortems are always useful. I recommend reading Irony Holder’s account in full (especially for the code error in the smart contract) but this is what I took away:

  • Part of the problem with IRON seems to be that the developers prioritised “efficiency”. In my experience the pursuit of efficiency has an unfortunate tendency to result in systems that are neither robust nor resilient – two highly desirable qualities in anything that facilitates the transfer of value. That observation (“efficient is rarely if ever resilient”) is of course based on the hard lesson that the conventional financial system learned from way it operated in the lead up to the Global Finance Crisis.
  • Algorithmic stablecoins like IRON appear to down play, or avoid completely, the need for high quality collateral. Experience in the conventional financial system suggests that collateral (ideally lots of it) is a feature of robust and resilient payment systems.
  • Yield farming around the IRON-USDC pair was producing extraordinary returns. High returns are a feature of the crypto asset world but maybe high returns on a stablecoin should have been a red flag?

I have over four decades of experience in the conventional financial system but I am a “noob” in this space (crypto-DeFi-digital) so the observations above should be read with that caveat in mind. It also important to remember that the issues above do not necessarily extend to other types of stablecoin. My understanding is that the algorithmic approach has not achieved as much traction as fiat and crypto collateralised approaches.

Hopefully you find the links (and summary) useful but also tell me what I am missing.

Tony – From the Outside